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I did try for a while, but it’s impossible to ignore anymore. The noise around Bitcoin has steadily risen throughout 2020 and it has now entered 2021 with a bang. This merits a few hundred words and minutes of time, if not more. While the statement may sound a tad cavalier, truth is that I’d be bluffing to say that I truly understood the potential of bitcoins (not in price but in utility). At the same time, it is just as true that my understanding of it as a potential asset for ‘investment’ is materially sounder.

In this blog I’m going to attempt to make sense of the bitcoin ‘investment’ without commenting on bitcoin as a potential global currency. Please bear with me and also understand I am not attacking this brilliant new technology or its viability in any way or form. All I’m trying to do is talk to you about whether it’s a rational investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... that fits into your wealth creation portfolio and in what proportion.

What is it?

At the outset, let me clarify that technology is not my strong point, hence understanding the nuances of new technology takes a while. Nevertheless, I have understood in a broad sense what Bitcoin and other similar crypto currencies seek to do. The origin, as is widely known now, did come about as an idea for an alternative to controlled fiat currencies. It came about as a retaliation to the lack of trust and small circle of control around fiat currencies.

Crypto currencies operate on blockchain technology where control is decentralized and no one person or group can affect the current worth of a single unit of currency. There is no way to deliberately inflate, deflate or debase the value of crypto currency. Governments world over are vary of this potential shift of purchasing power out of their hands. However, we must agree that central banks attempting to control the value of their currencies have really brought it upon themselves thanks to their apathetic muddling. The result of which has only been greater and wider income inequality and rising mistrust of the system that runs the mint.

The value ascribed to bitcoins

Bitcoins are mined digitally as a reward for a coding process that needs to be undertaken. Once mined and in circulation, they can be bought and sold on specialized exchanges just as you would other commodities. There is a transaction fee involved which presumably is what miners make money from.

Bitcoin is often equated with gold to determine its value without reference to the past price trend; it has even been called digital gold. One of the reasons for that is its limited supply. There are to be no more than 21 million bitcoins of which roughly 18.5 million are already in circulation. While it does look like the last leg of supply, in reality because of the way supply is structured, the bitcoin rewards given out to miners halve every 4 years and as a result the last of the supply will come into the market only in an estimated 100 years from now (not my estimate!).

Let’s also understand the reason why it is so popular. In the last decade, the world’s largest economies have indulged in mindless printing of money, backed by no real goods or services. As a result, the value of that money has declined steadily, which means your ₹100 is no longer capable of purchasing what it could ten years ago and its ability is depreciating at a very fast pace thanks to additional printing of empty money.

Bitcoin, just like gold, is seen as a store of value when fiat currencies are fast losing theirs.

This phenomenon has greatly influenced its popularity in the last one year where thanks to the pandemic we saw another large round of money printing world over.

There is an entire generation of people who have lost faith in traditional banking and rightly so.

Despite this background, I argue that Bitcoin is not a long-term investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains..., it is more in line with a volatile opportunistic trade. This does not take away from its utility as a currency and it is not very different from how some other currencies trade as well.

Can its price keep going up?

If you are looking for price gain, it can continue to happen for a long time to come. Nevertheless, there are some things you need to understand before putting your life’s earnings into bitcoins. There are a lot of people who are calculating the potential price rise in bitcoins by equating it to the market capitalization of gold, which is also a limited supply asset.

Where does that lead us? The current market capitalization of all the above ground estimated supply of gold is roughly $12 trillion, at this value given the potentially known 21 million bitcoins in forever supply, the per unit value of bitcoin is being pegged at $5,00,000-$5,50,000!

Now that’s a rally you want to be part of even if you have to wait 100 years!

The other thing that’s changed this year, is the interest shown by institutional investors in buying bitcoins. As per data from bitaps.com, there are at least 2340 addresses in the blockchain with more than 1000 bitcoins. The value of 1000 bitcoins at today’s price are roughly $38 million.

This points us firmly in the direction of institutional interest which is a catalyst in driving up price. Limited supply, heavy institutional buying, what else do you need for a rally?

Let’s look at history a bit, soon after 1970 when gold began to be considered as an investible asset and the gold standard was abandoned, the price rallied nearly 5 times in 5 years. Price went up 18 times by 1980, but so did inflationInflation is a common term thrown around in economics lessons and by politicians around election time. What it means in simple language is that prices of things you buy, stuff, keeps increasing every year. It happens because the economy in... More. Then for the next 20 years, gold prices fell to around one third their peak value. In the recent 20 years, gold has delivered roughly 8%-9% annualized return. It has spent 8 out of the last 10 years wallowing in a down trend before prices began to move up in late 2018.

As opposed to this kind of sharp sentiment driven up and down movement, good quality, long term revenue generating assets firstly display lower volatility. Secondly, analyzing the potential for price to pull back up or not is possible to a greater degree of accuracy thanks to tangible revenues to back price estimates.

The answer to the question, can price keep moving up, is actually not a simple one. Practically, yes, the price can keep going up. The question really is at what pace and with how much volatility?

The second more important question is whether you and your finances can stomach that volatility and for how long?

The risks can’t be ignored

Tech risks

Given that everyone likens bitcoin’s journey to gold, if we are going to take away that it derives its value from the principle of scarcity, then let’s also accept that there will be volatility in the journey, just like with gold. The big difference is that gold is a physical asset, one which you can touch and feel. Whereas, if tomorrow, 10 million bitcoins disappear or become inaccessible, there is nothing you can do about it (the fans will argue that it only adds fuel to the scarcity fire, hence, price needs to go up further!). Or if this super code is hacked into or another technology comes along to super cede it (chances of this risk playing out are perhaps the highest) making bitcoin redundant, it’ll be like the asset never existed. Technologies get overtaken all the time to be thrown into a tech blackhole (remember the floppy disk or the pager?). This is of course the worst-case scenario but it’s not implausible.

Market risk

The danger of over valuation is also a risk that we must face. Those who believe that simply the arrival of bitcoin will drive the value of the US dollar to zero are naïve. There are simply too many variables in that equation which are getting ignored in this simplistic narrative.

This is not to deny the utility of the bitcoin as a credible opposition, rather that, there are so many more qualifications it needs to acquire before it can challenge a fiat currency. Being decentralized is only one such degree.

Let’s be honest, bitcoins have been used to purchase stuff for nearly a decade now and yet despite investors piling into the trade, I don’t see the bitcoin currency being adopted globally for many years. There is a great deal that people don’t understand about how it operates. Moreover, as inequality has risen across the world, bitcoin vs USD is really a problem in the first world where everyone has access to the internet, electricity, social security and paid work.

Today people are ascribing it value on the basis of its challenge to the dollar, exaggerating its current value is a real possibility. An exaggeration beyond reason will lead to market overpricing the coin and that leads to risk of sharp and lasting correction. Asset return is not just what you earn now, rather the long-term potential.

Seen today, Bitcoin has delivered a staggering 163% annualized return in the last 5 years. However, bulk of that has come in the last 9 months, where its price moved from $ 5100 or so to now $ 41,000.

While we talk a lot about acceptance, the big change this year is really the sheer amount of money that’s available to invest in all kinds of assets including bitcoins; ironically, it’s this mindless money printing that bitcoins are intended to retaliate against to begin with.

Investment or trade

Before explaining this, I’d like to state that there is nothing wrong with trading if you know what you are doing and are able to bear the risk, just don’t confuse it with investing. As mentioned earlier, practically speaking the price of bitcoins can continue to move higher till eternity. However, you cannot deny it, its inherent volatility. When asset prices fall sharply there are usually some external factors at play and you go back to the drawing board to estimate the impact on revenue generation capacity of the asset. In case of a currency, there is no intrinsic value or revenue to assess. Value is what users ascribe it. The higher the usability of a currency, higher its acceptance, higher will be its value. This is perhaps what can be ascribed to bitcoin as well. At the moment the value being ascribed to the currency is supreme and that’s that. You can’t argue with it simply because it is the perspective of those buying this currency and it will remain so till something happens to change this perspective.

When the view changes, the same logic will apply in reverse. Those who believe that the view will never change will not only hold bitcoins at any price but also continue to buy at higher prices.

This makes it simply a trade prone to volatile shifts at random junctures in time.

Institutional investors

There is also the matter of institutional investors. In any asset, the entry of institutional investors impacts price positively as buying shoots up but also can have the effect of increasing risk. Unlike individual retail investors, institutions are fickle and nimble. They like one asset today and when return starts to narrow, they don’t like it anymore. Thing is that they can move out just as fast as they bought in. They work on strict allocations and stop losses. Individual investors on the other hand are not as well behaved and calculative. Hence, let’s take their interest with some cognizance of the risk it carries.

But, we are in a bitcoin bull market. That’s true, till we are not! If capital markets experience has taught me anything, it is that prices fall much faster than they can rise. That’s when institutional investors pull out faster than you can say ‘woah’!. Also, asset prices move in cycles, there is no such thing as a move in one direction; you either earn return today or spread out over time, can’t have it both ways. I am yet to hear an argument that makes me think it will be any different for bitcoin.

Why not spread out

I don’t own bitcoins because I am a conventional investor who believes wealth creation should happen through revenue generating assets. Never managed the US dollar or crude oil or gold trade and I doubt I’ll be able to manage bitcoins.

The trading nature of bitcoins make them riskier than a pure investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains.... Ask yourself if you are okay to lose 10%-15% of the value of your asset in a day? That too without knowing when and how this can get reversed. It might happen in a day or a month or never.

If your answer is yes, then as a test of your risk-taking ability take 20% of your investments or savings and just give it away or burn it.

Erase that real amount from your portfolio and see how you feel.

If you can do this without losing sleep, then maybe you can invest larger amounts in bitcoin.

For those who aren’t on board with the prospect of losing capital and not knowing when they will get it back, think about investing in bitcoin as you would budget for losing money in horse racing.

There is a fair chance that this horse will get ahead, but there are simply no guarantees and if it falters there is no way for you to gain back what you lost.

In simple words, its best not to put all your earned eggs in one basket and have an allocation that has more potential to give you gains in different market cycles. Today its Bitcoin’s time to shine, tomorrow another will emerge victor.

First choose assets that you understand, choose assets with fundamental value and then add amounts to assets like bitcoin that can give you an edge (only if you can manage the risk).

If bitcoin goes to $1,00,000 by the end of 2021, your 5% allocation would have earned you a neat 12.5% on $100. If it cracks you would have lost only $5.

It’s not that this is a safe way to do it, it’s that this is a wise way to do it simply because price is driven only by expected value and limited supply rather than real revenue.

End note

In the one week it has taken me to ideate, research and write this article the price of one bitcoin has moved up 28% from $32,000 to $ 41,000. I don’t know where it will be when this is finally published.

I leave it to you, ultimately the outcome of investing or trading is all about behaviour, nothing more and nothing less.

Please leave your comments and queries in the space below and let us know what else you would like to read about to resolve your money jigsaw.